2023-05-03 01:32:11 ET
Summary
- Chegg's Q1 earnings report led to a 48% drop in stock value, indicating a significant decrease in investor confidence.
- Its decision to increase share repurchases, while also investing all-in on AI, indicates a lack of clear vision and direction from management.
- Chegg's declining subscriber counts and revenue-per-subscriber metrics indicate a lack of loyalty among its customer base.
- Chegg's forward price-to-earnings ratio is currently at 13.1, which is expensive for a company losing users.
Recap
In the AI world, a blink can be a year.
On April 12, we wrote an article about Chegg , Inc. (NYSE:CHGG), stating that the company prioritized shareholders over customers, relied on a short-term acquisition growth strategy, and had an unconvincing vision and strategy.
The company released its Q1 earnings today. The stock dropped 48% after earnings. The company acknowledged that ChatGPT had an impact on its new customer growth rate. Now, the management has decided to go all-in on AI.
Key Takeaways from Q1 2023 Earnings:
- The company decreased its revenues by 7% in Q1, sequentially decreasing from -1% in Q4. Management points to a more scary deceleration in Q2, -14%.
- The company purchased $150 million worth of shares (5.7% of shares) in Q1 and expects to purchase another 7% of shares in Q2.
- Subscriber counts dropped 5% year over year from Q4 8% growth as the result of acquisitions.
Chegg also mentioned prioritizing resource allocation for CheggMate, new customer growth, and the skills business, and deprioritizing areas that are not related.
What is CheggMate
In its earnings call, Chegg announced its new AI-enhanced learning service, CheggMate, which leverages OpenAI's most advanced model, GPT-4, to provide students with personalized learning pathways, quizzes and tests, and context to guide their learning journey. This service will be available to its users this month.
According to the management, CheggMate will have a cooler and more conversational interface compared to ChatGPT. It will be personalized, know your class and textbook, and be able to write prompts for you based on other questions asked. It will feel like a live tutor and include gamification elements. CheggMate will be able to program in advance what you're likely to have to know based on the things you already knew because Chegg has the history of 10 years of that particular class.
The company believed that its business could benefit from AI instead of being threatened by it. Its survey of users suggests people still prefer AI tools supported by human expertise.
In a recent study, 77% of Chegg customer s said they are excited by AI chat-based learning support, but 85% of students said that they would prefer it if it is supported by human expertise.
Chegg believed this was a short-term challenge for the company to address the needs of students who only want quick answers.
Chegg is Just a Tool
We believe that the company overestimated its utility for the students.
In fact, we believe that the company had low loyalty among its base customers. This can be revealed by (1) the seasonality of its subscriber counts, (2) decreasing revenue per subscriber.
Seasonality
The company had 5.4, 5.3, 4.8, and 5.4 million subscribers in Q1, Q2, Q3, and Q4 in 2022. It explained this in its 10K by blaming a change in the academic calendar.
As a result of this seasonality, which corresponds to the academic calendar, our revenues may fluctuate significantly quarter to quarter depending upon the timing of where we are in our "rush" cycle and sequential quarter-over-quarter comparisons of our net revenues and operating results are not likely to be meaningful. In addition, shifting enrollments could impact the seasonality of our business and further make our results of operations difficult to predict.
This, in our opinion, reflects a lack of loyalty. The market is flooded with free AI tools if the customer views Chegg's service as nothing more than a tool. Its customers won't think twice before canceling and switching when better choices emerge.
Decreasing revenue per users
Despite expanding its operations through various acquisitions, the company's performance has not been improving. Over the past three years, the company's top-line revenue has increased, but the revenue-to-subscriber (rev/sub) ratio has declined. This ratio is an important metric in the subscription industry because it shows the firm's pricing power and is usually used to gauge customer retention. According to the metrics shown in the table below, the company's customer retention rate has been dropping over time.
The decline in the company's revenue-to-subscriber metrics in Q1 2023 further compounds the situation. Contrary to the 8% gain in Q4 2022, the company's subscriber count unexpectedly dropped by 5% in this quarter. This decline in subscribers can result in reduced revenue in the future.
Acquisition Strategy in Question
This is a concerning sign, as retaining existing customers is often more cost-effective than acquiring new ones. If the company's retention issues persist, it may also be a sign that it overpaid for its acquisitions or that it hid the fact that its customer base was already shrinking.
By March 2023, it had goodwill valued at $615 million. Following the release of its earnings report, the market capitalization of the company dropped to $2.1 billion. While goodwill impairment may not have an immediate cash impact on the business, it can send a negative message to investors regarding the company's financial performance and prospects. The potential impairment of goodwill can imply that the future cash flow of the company might decrease.
Chegg Can Burn its Bridge
It is not realistic to assume that you can maintain a weakly loyal customer base by leaving them to fend for themselves. In fact, the introduction of CheggMate may hasten the demise of this customer base in multiple ways.
- Users can now learn about ChatGPT through Chegg if they don't know about it or haven't used it. The freemium model of ChatGPT can successfully entice some Chegg customers. Absolutely, there may be some retention benefit with the introduction of CheggMate in short term. Long term, however, this company will face more margins pressures as the competition increases. Numerous programs or tools have been developed using ChatGPT by third parties. Without a strong core, in our opinion, CheggMate will eventually turn into a traffic generation tool.
- Additionally, due to concerns about proprietary data leaks, many companies have prohibited the use of ChatGPT. Integrating ChatGPT into Chegg's system may have advantages, such as enhancing the company's offerings and providing better services to its users. However, it also comes with potential risks that could have severe consequences for the company, such as losing its proprietary data.
What is Skills
According to the management, Chegg was betting big on its Skills business.
What is Skills? In a word, it's Chegg's online school. Its skills-based learning service offers professional courses along with networking, interviewing, and career services. In 2022, this business accounts for 12% of its total revenue. The average price of the Skills business was closer to $5,000 and had high gross margins. Chegg believed that the Skills business may expand and contribute significantly to its revenue.
In our opinion, this industry is already very competitive. In the realm of education, having a solid reputation is crucial to attracting prospective students and building credibility with employers. Unfortunately, when compared to other well-established universities and colleges, Chegg's reputation has yet to attain widespread recognition. In addition, large tech corporations like Google and Microsoft have their own certificate programs. These programs have already gained widespread recognition and are often preferred by recruiters.
Thus, we don't think the company can grow much in the space as it lacks a competitive advantage in the space.
Valuation
Keeping a market capitalization of $2 billion can be difficult, especially when you have a large customer base of 8 million users who exhibit low levels of loyalty. This indicates that investors are essentially paying a premium of $250 per subscriber, which is significantly higher compared to the $82 per user that investors pay for Spotify's stock.
The company's forward price-to-earnings (FWD P/E) ratio currently stands at 13.1x. There is a possibility that the estimated earnings for 2023 will be revised downward by analysts, which would result in a higher FWD P/E ratio.
However, even a 13.1 P/E ratio is too expensive for a company that is losing users. When a company is losing users, it means that its marketing expenses should be deleveraging. Not to mention, as discussed above, the competition in the space will become fiercer as ChatGPT joins. Thus, this company can lose more margins in the long term. If a company experiences a decline in its profit margins, it can lead to a decrease in its stock valuation multiple.
In addition, there is downside due to the top-line loss. The company's last attempt to go all-in with ChatGPT, we think, was the last straw. It kills all hope for its long-term investors.
Share repurchase
The company plans to buy more shares in Q2. For us, this makes absolutely no sense. The company opted to raise the buyback just when it stated its intention to increase its investment in AI. The AI competition is just starting. It's important to save resources and stay focused. This clearly shows us that management did not have a clear vision of where it was going. In addition, a firm in decline will not benefit much from a buyback.
Summary
Chegg reported bad earnings and decided to chase the hot topic in the market as it always did in the past through numerous acquisitions. The company decided to invest all-in in AI while it accelerated its buyback. Instead of focusing on improving its core strengths, the company decided to call for help. The capital market is useful for those who help themselves. Its declining retention metrics already revealed its serious problem ahead of this earnings release. Its future picture became more vague for us after its decision to integrate ChatGPT. We consider its valuation multiple to be still too high and not sustainable given that its user base is in decline. We rate the company "Sell".
For further details see:
Chegg: Big Bet On AI, This Is What You Need To Know